Stochastic duration and fast coupon bond option pricing in multi-factor models

Abstract

Generalizing Cox, Ingersoll, and Ross (1979), this paper defines the stochastic duration of a bond in a general multi-factor diffusion model as the time to maturity of the zero-coupon bond with the same relative volatility as the bond. Important general properties of the stochastic duration measure are derived analytically, and the stochastic duration is studied in detail in various well-known models. It is also demonstrated by analytical arguments and numerical examples that the price of a European option on a coupon bond (and, hence, of a European swaption) can be approximated very accurately by a multiple of the price of a European option on a zero-coupon bond with a time to maturity equal to the stochastic duration of the coupon bond.

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Munk, C. Stochastic duration and fast coupon bond option pricing in multi-factor models. Review of Derivatives Research 3, 157–181 (1999). https://doi.org/10.1023/A:1009654427422

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  • the term structure of interest rates
  • stochastic duration
  • multi-factor models
  • coupon bond option pricing
  • swaption pricing